Private real assets are one of the most attractive investment sectors today with excellent return prospects, real diversification properties, and inflation-hedging capabilities. In particular, the shale revolution taking place in the US is providing plenty of upstream and midstream opportunities for experienced energy investors.
But there are three big challenges facing real assets investors in 2014, each of which comes with a health warning. These are: addressing the limited track record of most private infrastructure managers; resisting the lure of renewable energy; and resisting the exotic attraction of emerging and frontier markets.
Analysing infrastructure managers
Many institutional investors are rightly attracted to infrastructure, with its promise of long-term cash flows backed by tangible assets. Some include infrastructure as part of a well-diversified real assets allocation, while others create a separate asset class for infrastructure. Private infrastructure is an emerging, but still immature, asset class. Only the traditional energy infrastructure sub-sector has a long and robust track record.
It is difficult to evaluate infrastructure managers because the vast majority have a limited operating history and track record – at least as a team at their current firm. If track records do exist, they were often generated at prior managers or under the umbrella of a different organisation. As an extreme example, a prominent infrastructure group has splintered into two new firms, while the original remains in business. Not surprisingly, all three teams are claiming the good deals as part of their track record, while disclaiming responsibility for the bad ones.
Many deals done just prior to the financial crisis have struggled or gone bankrupt. Does this indicate poor management, or were these failures simply the result of the optimistic environment at the time, followed by the Great Recession? In addition, there have been very few “clean” exits from infrastructure projects. Many so-called exits have simply been transfers to related and longer-dated funds.
Therefore, extensive due diligence is crucial in choosing infrastructure managers. Multiple meetings with all senior partners in all key office locations is required to wade through the marketing hype and determine which managers possess the critical skills necessary to develop, build, and/or operate infrastructure projects and generate attractive returns for investors. We spend much time and effort sourcing and analysing managers, digging deep to separate the wheat from the chaff. It remains a difficult task.
Resisting the lure of renewable energy
Avoiding trendy fads has been an investment challenge since the well-known Dutch tulip bulb boom and bust in the 1600s. Today, one such crowd favourite that we are constantly cautioning investors about is renewable energy. I believe history will record 2013 as a turning point when the bloom finally fell off the rose of renewable energy.
The most visible illustration of this was the well-publicised remarks of CalPERS chief investment officer, Joseph Dear (now deceased), at a conference in 2013. He spoke from considerable experience and told attendees that the large CalPERS allocation to clean energy had suffered losses of almost 10 percent per annum since its 2007 inception. Dear was widely quoted as saying: “We’re all familiar with the J-curve in private equity. Well, for CalPERS, clean-tech investing has got an L-curve for ‘lose’. Our experience is that this has been a noble way to lose money.”
Altius regularly warns its clients about the dangers of investing in assets where the main sources of return are mandates (i.e. forced purchases), tax credits, and subsidies. In other words, renewable energy represents more of an investment in political decisions than in tangible assets. Unfortunately, when the inevitable – and considerably higher – electricity bill comes due, constituents start complaining and politicians start breaking their promises and reneging on their contracts. Germany is a prime example at the moment. We agree with the headline writer who summed up the sector this way: “Green Investing: So Much Promise, So Little Return”.
Resisting the lure of emerging and frontier markets
For many years, we have marveled at the number of investors which expect an almost certain premium from investing in emerging or frontier markets. The assumption is that higher risk automatically equates to higher returns. In most real assets sectors, however, emerging markets have certainly given investors more risk, but have rarely produced positive – let alone premium – returns.
Although there are exceptions, energy, timber, and infrastructure investments located in emerging markets have generally struggled. The many risks are often given only cursory thought, downplayed by managers for self-serving reasons, and grossly under-estimated by investors. Many aspects of life we take for granted in the developed markets – basic infrastructure, the rule of law, functioning markets, work habits, reliable communications, electricity, etc. – are often absent or sub-par in emerging markets. Local partners are a necessity and often do not possess the same level of ethical standards that we expect in developed markets.
In short, we urge caution – and significant underweighting – for real assets in emerging markets (with the possible exception of mining). Developed markets offer plenty of attractive opportunities today, with lower risk and, we believe, a strong likelihood of higher returns.
* Jay Yoder, CFA, is head of real assets at Altius Associates